Over the past few years, state programs addressing climate change in general and emissions from greenhouse gases more specifically have proliferated. They run the gamut from renewable energy portfolio standards in about 20 states to a proposed carbon dioxide (CO2) emissions standard for automobiles in California. Perhaps the most significant of these programs is the joining together of nine northeastern states to develop a regional cap-and-trade program known as the Regional Greenhouse Gas Initiative (RGGI).

RGGI was launched in April 2003 when New York Governor George Pataki sent letters to fellow governors in the region proposing an emissions trading program. Initially, RGGI seeks to address CO2 emissions from the electric power sector. Ultimately, the program may be expanded to include additional sectors and other greenhouse gases (GHGs). RGGI advocates argue that the program could serve as a model for a future national GHG cap-and trade program.

Programs such as RGGI have engaged state policymakers and stakeholders in the important task of reducing greenhouse gas emissions. However, they also raise a number of questions, including what the role of state governments should be in climate change, which is essentially a global problem. Also, given the need for a national if not international solution, will state programs help or hinder the development of effective national institutions for emissions trading? In particular, can states pioneer innovative approaches to some of the unique issues associated with emissions trading of greenhouse gases?

Our answer to these questions is that despite some significant challenges, efforts like RGGI can offer the chance to experiment with some of the features and institutions that will be needed for future national efforts to address greenhouse gases.

Does State Action Make Sense?

Unlike many of the pollutants we are used to dealing with, greenhouse gas emissions are a global phenomenon. Ton for ton, CO2 emitted in the northeastern United States matters no more for climate change in the region than CO2 emitted in China; emissions from cars and power plants are the same as emissions from residential furnaces. If state actions do not lead to longer-term, comprehensive federal and international action, they will not make a significant impact on climate change. This differs dramatically from smog, particulates, and acid rain: the emissions that cause these problems are created locally from smokestacks and traffic and have mostly local and regional impacts.

A regional greenhouse gas cap-and-trade program like RGGI poses additional challenges because companies can simply shift emissions to unregulated emissions sources outside the region, causing what is known as leakage. For example, limits on power plant emissions in the RGGI region may simply shift power generation to other parts of the country. In theory, total emissions could even increase, if regulated gas generation in the Northeast, for example, is shifted to unregulated coal generation in the Midwest. This problem is considerably less important under a national program, where the flexibility to move economic activity out from under the cap is lower.

Ultimately, whether leakage is a small or large problem for RGGI will be determined by a number of factors, including the level of the emissions cap and constraints on the electricity transmission system that may mitigate leakage. Stakeholders have suggested several solutions, including regulating distribution rather than generation of electricity within the region or regulating regional electricity imports as well as generation.

Although such solutions are feasible if leakage is deemed a significant problem, we believe that care should be taken to avoid complex design features that would complicate implementation, particularly because these features would become obsolete if the United States adopted a national program. Instead, RGGI could focus on innovative solutions to problems more relevant to a national program and address leakage by implementing a more modest cap level.

Experimenting with Innovations Necessary for Greenhouse Gas Trading

Although a state approach to greenhouse gas trading presents challenges such as leakage, RGGI policymakers also have an opportunity to experiment with several innovative features that could be useful for a potential future national cap-and-trade program to address greenhouse gases. Several of these features are discussed below.

Testing Emissions Allowance Approaches

Allowance distribution is one of the most contentious issues policymakers face in designing a cap-and-trade program. Allowances are a valuable asset, created alongside an equally large liability for future emissions, and the distribution of this asset has important implications. Even with a modest target, the value of allowances in a national GHG trading program could be 10 (or more) times larger than those in the sulfur dioxide trading program (currently the largest and most successful emissions trading program in the country). As a result, allowance distribution for a national program will raise significant issues of fairness.

Under RGGI, innovative allocation approaches at the state level could be tested, such as auctioning portions of the annual allocations or allocating some allowances (or the revenues from the sale of allowances) directly to groups that are adversely affected by the costs of a cap-and-trade program. State governments could also experiment with alternative formulas for allocating to existing sources and addressing new source needs. These approaches could be helpful to developing a strong national program in the future.

Developing an Effective GHG Offset Program

Offsets could be a particularly cost-effective way to reduce the costs of a mandatory greenhouse gas program. Unfortunately, there are no functional models for offset programs to draw upon. Although project-based emissions offset programs for conventional pollutants have been around for many years, many have had limited effectiveness because of high transaction costs and uncertain environmental integrity. More recently, the Clean Development Mechanism (CDM), an effort to incorporate offsets from developing countries used under the Kyoto Protocol, has been costly and cumbersome.

If RGGI states advance an environmentally credible program with low transaction costs, they would make an enormous contribution to a future national program. To this end, RGGI policymakers and stakeholders have discussed developing performance standards and other transparent, objective criteria that would provide clear signals to investors about the types of projects that would be acceptable and the volume of credits that would be generated.

Exploring International Linkages

RGGI's launch has sparked great interest in Europe, where an even larger experiment with GHG trading began on January 1, 2005. There have already been informal contacts between state officials and officials of the European Commission and European member states to share information on how the new European Emissions Trading System (EU ETS) is developing. These informal contacts may provide opportunities to explore linking issues that will be useful for any future greenhouse gas program seeking to trade with the EU ETS. A consensus is growing that if or when the United States adopts mandatory GHG reductions, the most likely approach to international trading would be to first develop the national program and then negotiate trading agreements with other countries. Questions on linking that might be explored in the RGGI effort include:

What metrics will be used to determine whether cap levels are compatible in linked systems?

What are the implications of using offset credits from the Clean Development Mechanism or allowances from the EU ETS in the RGGI program?

What enforcement and compliance issues arise when there are trades that cross national boundaries?

Ultimately, we believe that RGGI can be a valuable building block for a national climate policy if it is designed in ways that allow it to be successfully scaled up to a federal, multisector cap-and-trade program. Policymakers and stakeholders should focus on keeping the design as simple as possible. An emphasis on creating the right institutions is more important than pushing for an overly stringent short-term emissions cap that might place the region at an economic disadvantage, require special mechanisms to combat leakage, and prove to be politically untenable.

Specifically, we believe RGGI should experiment with new approaches on allocation, offsets, and other features that could develop useful experience and set positive precedents for a future national effort.